Scheme Liability Under Rule 10b-5: An Emerging Cause Of Action - Part I

Friday, December 1, 2006 - 01:00

Over a decade ago, the United States Supreme Court in Central Bank of Denver N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) ruled that there is no private cause of action for aiding and abetting securities fraud under Section 10(b) of the Securities Exchange Act and Rule 10b-5. At the time, it was widely believed that this decision would limit the ability of securities class action plaintiffs to bring claims against secondary actors, such as lawyers, accountants, and investment bankers, that did not make or cause to be made any false or misleading statement or omission by an issuer. Recently, however, it has become common for plaintiffs to bring claims against secondary actors under a theory of direct 10b-5 liability, known as 'scheme' liability, that rests not on the making of any false or misleading statement or omission but on participation in a scheme to defraud. Within the last year, significant decisions have issued from the Ninth Circuit, the Southern District of New York, and the District of Massachusetts purporting to set the parameters for scheme liability as a cause of action under Rule 10b-5. Even so, there is a lack of consensus among courts as to what such a cause of action entails or whether it even exists.

Beyond the legal debate, the validity of scheme liability as a cause of action under Rule 10b-5 has significant implications for business in the post-Enron world. Increasingly, aggressive plaintiffs' lawyers are casting a wide net when it comes to 10b-5 claims, capturing not only the professional advisors and gatekeepers that are traditional secondary actors but also arm's-length business entities and potentially anyone else who does business with a public company. This is a significant expansion of liability under Rule 10b-5 with potentially far-reaching implications.

This article examines the relevant background to the controversy over scheme liability, including the Supreme Court's ruling in Central Bank and its precursors, reviews cases analyzing scheme liability, and offers a view as to the viability of scheme liability as a cause of action under Rule 10b-5.

Background: The Parameters of Rule 10b-5 Liability

The starting point for any discussion of anti fraud liability under the Securities Exchange Act is Section 10(b) itself. This section makes it unlawful 'to use or employ, in connection with the purchase or sale of any security any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.' 15. U.S.C. 78j(b). Pursuant to this statutory mandate, the SEC promulgated Rule 10b-5, which contains three prohibitions. Under Rule 10b-5, it is 'unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) to employ any device, scheme, or artifice to defraud,

(b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading or

(c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.'

17 C.F.R. 240.10b-5.

The SEC, in announcing the adoption of Rule 10b-5 over 60 years ago, failed to shed much light on its intended scope. The Commission's short public statement made only the modest claim that Rule 10b-5 'closes a loophole in the protections against fraud administered by the Commission by prohibiting individuals or companies from buying securities if they engage in fraud in their purchase.' Employment of Manipulative and Deceptive Devices, Exchange Act Release No. 3230, 1942 SEC LEXIS 485 (May 21, 1942). However, some insight into Rule 10b-5's scope may be gained from the language of Section 10(b) itself. See Ernst & Ernst v. Hochfelder , 425 U.S. 185, 214 (1976) (noting that the scope of Rule 10b-5 'cannot exceed the power granted the Commission by Congress under 10(b)'). In this regard, Section 10(b), by its terms, purports to address two forms of unlawful conduct: that which is 'manipulative' and that which is 'deceptive.' Although the statute itself does not define 'manipulative' or 'deceptive' conduct, the legislative history to the Exchange Act indicates that Congress sought to address two related but distinct forms of wrongdoing - manipulative securities trading schemes such as wash sales and matched orders that were 'designed to create a misleading appearance of activity with a view to enticing the unwary into the market' and '[f]alse and misleading statements designed to induce investors to buy when they should sell and to sell when they should buy.' See H.R. Rep. No. 1383, 73d Cong., 2d Sess. 15 (1934).1

Historically, the United States Supreme Court has declined to expand the scope of Rule 10b-5 beyond Section 10(b)'s requirement that conduct prohibited by the statute involve a manipulative or deceptive act. For example, in Ernst & Ernst v. Hochfelder, the Supreme Court overruled a Court of Appeals decision permitting claims for negligent conduct pursuant to Rule 10b-5 and, based on a close reading of the statutory language and legislative history of Section 10(b), held that scienter, or 'a mental state embracing intent to deceive, manipulate, or defraud' was required to establish a violation of 10b-5. 425 U.S. 185, 193 (1976). In reaching that decision, the Ernst & Ernst Court noted that: 'when a statute speaks so specifically in terms of manipulation and deception, and of implementing devices and contrivances - the commonly understood terminology of intentional wrongdoing - and when its history reflects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct.' Id. at 214. One year later, in Santa Fe Industries, Inc. v. Green , 430 U.S. 462 (1977), the Court declined to extend Rule 10b-5 to claims of breach of fiduciary duty not involving a false statement or omission and noted that, irrespective of the breadth of Rule 10b-5's language, neither the language of Section 10(b) nor its legislative history gave any indication that Congress 'meant to prohibit any conduct not involving manipulation or deception.' Id. at 473.

Twenty years after Ernst & Ernst and Santa Fe Industries , the Supreme Court again had occasion to consider the scope of Rule 10b-5. The issue in Central Bank of Denver was whether liability under Section 10(b) and Rule 10b-5 could extend to those who did not themselves commit a manipulative or deceptive act but who facilitated the commission of such an act by another person. In ruling that liability under Section 10(b) and Rule 10b-5 did not extend to those who merely 'aid[ed] and abet[ted]' another in the commission of a manipulative or deceptive act, the Court viewed as determinative the language of Section 10(b), which makes no mention of aiding and abetting. Id . at 164. Construing the scope of conduct prohibited by Section 10(b), the Court concluded that 'the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act.' Id. at 177. Consequently, aiding another's fraud was simply not within the scope of conduct prohibited by Section 10(b). Id. Further supporting its decision, the Court noted, was the lack of any reliance placed by the plaintiff on an 'aider and abettor,' whose identity or role in the fraud typically is not publicly known. Id. at 180. In the Court's view, permitting an aiding and abetting action would allow plaintiffs to circumvent 10b-5's reliance requirement and 'disregard the careful limits on 10b-5 recovery mandated by our earlier cases.' Id.

In reaching its decision, the Central Bank Court was not unmindful of the practical consequences of imposing liability for aiding and abetting another's Rule 10b-5 violation. The Court expressly noted that, as a matter of public policy, the lack of clarity surrounding the parameters of aiding and abetting liability, coupled with a 'vexatiousness [in being forced to defend a 10b-5 claim] different in degree and in kind from that which accompanies litigation in general,' supported its decision that aiding and abetting was not a viable cause of action under Rule 10b-5. Id . at 189. In particular, the Court expressed concern that due to the uncertainty of the rules governing aiding and abetting liability 'entities subject to secondary liability as aiders and abettors may find it prudent and necessary, as a business judgment, to abandon substantial defenses and to pay settlements in order to avoid the expense and risk of going to trial.' Id.

The Wake of Central Bank: 'Substantial Participation' versus 'Bright Line'

In the wake of the Supreme Court's decision in Central Bank of Denver , federal courts have grappled with the question of when a secondary actor's conduct gives rise to primary liability under Rule 10b-5. In answer to this question, two competing modes of analysis have emerged: the 'substantial participation' test and the 'bright line' test.

Under the 'substantial participation' test, which has been adopted principally by the Ninth Circuit and by a number of district courts, a secondary actor may be liable under Section 10(b) if he or she 'substantially participates' in the creation of a false statement or omission by others. See In re Software Toolworks, Inc. Secs. Litig. , 50 F.3d 615 (9th Cir. 1994). For example, in In re Software Toolworks , the court held that an accounting firm could be found liable as a primary violator based on false statements contained in two letters submitted by its client to the SEC. Although the accounting firm did not sign or issue the letters, primary liability was appropriate, the court held, because the firm had 'played a significant role in drafting and editing' the letters. Id. at 628. Similarly, the district court in In re ZZZZ Best Securities Litigation , 864 F. Supp. 960 (C.D. Cal. 1994) held that an accounting firm could be liable as a primary violator under Rule 10b-5 for another's false statement based upon 'extensive' participation in the creation of the statement.

Under the 'bright line' test, which has been adopted by the Second, Tenth, and Eleventh Circuits, a secondary actor can be liable under Section 10(b) only if he or she actually made a false statement or omission on which the plaintiff relied . See Shapiro v. Cantor , 123 F.3d 717 (2d Cir. 1997). In Shapiro v. Cantor , the Second Circuit, on facts similar to those of In re Software Toolworks and In re ZZZZ Best , held that an accounting firm that had participated in creating allegedly false statements issued by its client could not be liable under 10b-5 because it had not actually made a false statement or an omission. The Second Circuit expressly declined to follow the 'substantial participation' test, noting that

if Central Bank is to have any real meaning, a defendant must actually make a false or misleading statement in order to be held liable under Section 10(b). Anything short of such conduct is merely aiding and abetting, and no matter how substantial that aid may be, it is not enough to trigger liability under Section 10(b).

Id. at 720.

The Second Circuit found that, in the wake of Central Bank , 'a claim under 10(b) must allege a defendant has made a material misstatement or omission indicating an intent to deceive or defraud in connection with the purchase or sale of a security.' Id. at 721.

The Second Circuit's holding in Shapiro , reaffirmed one year later in Wright v. Ernst & Young LLP , 152 F.3d 169 (2d Cir. 1998), seems to be the right result under Central Bank . It is difficult to distinguish participation in the creation of another's false statement from traditional 'aiding and abetting.' Moreover, it is unclear how courts applying the 'substantial participation' test would address the reliance requirement under Rule 10b-5. Neither In re Software Toolworks nor In re ZZZZ Best mentions reliance but, as the Second Circuit noted in Wright , holding a secondary actor liable under Rule 10b-5 for another's false statement 'would circumvent the reliance requirements of the Act' because 'reliance only on representations made by others cannot itself form the basis of liability.' Wright , 152 F.3d at 175 (internal citations omitted).

1 The meaning of the term 'manipulative' as used in Section 10(b) was further delineated by the United States Supreme Court in Santa Fe Industries, Inc. v. Green , 430 U.S. 462 (1977). There, the Supreme Court defined 'manipulative' as a 'term of art' which, within the meaning of Section 10(b), 'refers generally to practices such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity.' Id. at 476-77.

James C. Dugan is a Partner at Willkie Farr & Gallagher LLP in New York City. He specializes in federal securities litigation, accountant's liability, and corporate internal investigations. The author would like to thank Antonio Yanez, Jr. and Rebeccah Niesen for their contributions to this article.

Parts II and III of this article will appear in the January and February issues of The Metropolitan Corporate Counsel.